The End of a 30 Year Bond Bull Market

Saturday, April 15, 2017

Government bonds are supposed to be risk-free assets. UK gilts and German bunds being perhaps the most secure. With the ECB starting their €60bn pm QE programme in March, this prompted investors to rush to bonds. The general consensus was that the QE programme would buy up the Eurozone bonds on offer and the resultant scarcity would push up prices even if yields fell to zero. Buyers crowded the small market. Within weeks of the start of Mr Draghi QE programme, the spectre of deflation was removed with low borrowing costs, rising oil prices, and economic growth. Future inflation was back on the agenda and with this yields soared to compensate investors for the risk of future inflation. With rising yields came falling prices. Government bonds have been on a bull market since the early 1980’s on the back of low interest rates. Yields have been exceptionally low and hence bond values have been expensive. This is particularly true if yields are less than inflation or near zero.

The recent uplift in oil prices and business growth in the Eurozone particularly in Spain eased fears of deflation which Mr Draghi’s programme was designed to prevent. If inflation is to return to Europe, zero bond yields are not acceptable and therefore will have to rise. The normally safe and secure government bond market saw ultra-low yields rising by 20% or more with a corresponding fall-off in value. German Bunds, for example, lost 15% in value in early May. Across Europe, sovereign bonds have seen dramatic rises in yields and resulting falls in capital values representing big losses. The sell-off was described by Goldman Sachs as “large and vicious”.

This bond market re-adjustment could signal the end of a 30 year bond bull market as capital values have kept growing on the back of progressively declining yields due to lowering inflation and interest rates.

There are some good reasons to believe that a bear market in bonds may be premature. Investors have not moved out of fixed interest securities and the Eurozone recovery is only just starting. Recent good news in Spain, France and Italy was offset by disappointing news elsewhere. With unemployment still very high we are not likely to see inflation become a problem in Europe for some time. Therefore the ECB are most likely to keep printing money as they have stated, until September 2016 at the earliest. Central Banks are also in no hurry to raise interest rates. This should, going forward, keep the lid on sovereign bond yields and support bond prices. Either way, government bonds remain an unattractive investment.

A major question for bond holders is what will happen once central banks do begin to raise interest rates? The government bonds from countries such as the US, the UK, Germany and Japan all have high credit ratings and therefore yields are determined by the outlook for interest rates. Short duration bonds (less than 10 years) are influenced by current interest rates, while long term bonds are affected by how investors expect rates to change in the years ahead. This is equally true of corporate bonds.

The rout in government bond values in May intensified fears amongst analysts over the lack of liquidity in bond markets. A big sell-off in gilts, corporate bonds and high-yield bonds perhaps triggered by the start of potential US interest rate rises in October 2015; ECB tapering QE after September 2016; or the emerging markets struggling with rising US$ values, would create major liquidity problems as sellers crowd the exits. Bonds by their nature tend to be attractive to cautious and often retired investors, those least wanting to tolerate losses.